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Brazilian Real Estate: A tale of two cities

Two pools (one for adults, the other for kids), a cinema-café complex, a meditation space, spa, saunas, putting range, climbing wall, baby park, and skating centre, oforu (a kind of Japanese bath) and shiatsu. And the list goes on. But this is not a piney Californian retreat for de-toxing celebrities, but the launch of a new-build, San Geminiano, in a middle class suburb of Rio de Janeiro, not much more than a stones throw from the favela where the notorious film City of God was filmed. It is just one of many such ritzy launches going up across that city and its big rival São Paulo.

The copy may be hot, but the Brazilian real estate sector is not. The sector, when including real estate brokers and property developers, saw 34 IPOs in 2006 and 2007. Foreign investors heavily subscribed to these deals and, except for one purely domestic deal, never snapped up less than 53% and in one case accounted for a whopping 98%. They were wowed by the copy, seeing in a country that needed eight million new homes and where housing financing has been virtually non-existent, an opportunity for all-comers. But with an obsessive concentration on the two metropolises of Rio de Janeiro and São Paulo, real estate companies haev not unlocked the potential of Brazils many other under-served other markets. At least for now.

Share prices have wilted  in some cases by more than 70% in the last 12 months-- and the sector has entered the investor hall of shame. Only a couple of firms have really been able to ride the storm. In addition to the size of the free float, an emphasis on geographic spread and a diversified portfolio of building types, together with a keen eye on costs has been central to success. Even they are being tested by a new wave of interest rate hikes as Brazil seeks to fight inflation. But for investors with an eye on the longer term, those real estate companies that survive what looks likely to be a coming shake-out should reap generous rewards.

Background
Its important to look at the background to trace the huge wave of interest in the housing market in Brazil. The history of hyper-inflation in the mid-80s and the various plans to combat it ensured that most real estate companies remained pygmies. Even after inflation was slayed by the 1994 real plan, high rates prevented all but the wealthiest and most cash rich from buying houses. And that helps to explain the continued obsessive focus on the wealthy, upper middle class of Rio and São Paulo in real estate business plans.

In the last five years, it seemed for the most part that Brazils sky-high interest rates were destined to converge with rates in the developing world, cracking open the real estate market. That has started but recently stalled. A history of hyper-inflation, a hawkish central bank governor and a Federal government that shows no signs of tackling its spending rises, has seen the Central Bank act aggressively to fend off inflation this year. The governments lack of spending control means were firing on one cylinder, says Marcelo Salomon, chief economist at Unibanco.

A new upward cycle in rates started in April and in July, the Central Bank raised rates 75 basis points, bringing them up to 13%. Most economists see rates heading up steadily for the rest of the year reaching anywhere between 14-15% by year-end and only falling slowly sometime in 2009, assuming that global inflationary pressures stabilize.

This is not the only headwind for the real estate sector. The international credit crisis has lapped only gently on Brazils shore, but it is arriving. It is particularly affecting smaller- and mid-sized banks that were just getting ready to roll out real estate products. They are finding capital markets closed and are scaling back or eliminating plans to provide long-term loans. Morris Dayan, executive director at the mid-sized São Paulo based bank Daycoval, says they are no longer interested in investing in real estate, at least until rates clearly resume a downward trend.

And even the largest Brazilian banks are tightening their belts, facing higher costs of funding and greater fears that monetary tightening will lead to consumer defaults. They are understandably applying more stringent credit conditions and seeking to moderate the way they grow long-term portfolios. Márcio Cypriano, president of giant Banco Bradesco, says he intends to push ahead with plans to triple lending to R$6 billion this year from R$2 billion in 2006. Still, he adds that overall the bank is ratcheting up credit conditions by requiring tougher credit scores and reducing tenors of loans. We are looking to be very cautious in managing risk, he says. That suggests that at the very least growth in real estate portfolios will moderate in the short-term.

The rises in interest rates have spooked investors, who were betting on regular falls in rates, and a sustained uptick in longer-term lending by banks feeding into a growing mortgage market. Put that together with tighter liquidity conditions globally and a strong emphasis on the most liquid names and you can see why Brazilian real estate companies have fallen out of fashion fast.

While it is true that the short-term macroeconomic background is not favourable to real estate companies, plenty of things that are going right for the sector are being ignored by investors. Recent changes in the law mean that Brazilians can dip into their Fundo de Garantia de Tempo de Serviço, a compulsory contribution to a fund traditionally used for pensions. For many workers, this can cover one third or more of the price of a home and is increasingly used to fund purchases, bringing down total borrowing.

Brazilian companies are also caught up in a wider disdain for property brought about by the excesses in the United States and key European markets. But the link is decidedly tenuous. In Brazil, mortgages represent just 2% of GDP compared to some 80% in the United States. And the long-term story of falling rates, growing GDP and a massive housing shortage remain in place.

Investor Pickiness
The temporary upward blip in interest rates is probably not the largest obstacle to a return to health of the sector. The bigger issue now is lack of access to fresh sources of capital. Investor enthusiasm lay behind a rush by firms, encouraged by investment banks, to come to market, regardless of readiness. Real estate firms were naturally keen to oblige this interest because of the premiums being paid for the sector. There was also the fear of eat-or-be-eaten amid a widely-predicted consolidation of the industry that has still mostly failed to materialize.

More recently, the role played by the size of free float and the overall company has been critical. A resolute focus on large, liquid names has side-lined smaller companies and a vicious circle created whereby only the largest companies are considered to have potential for future fund raising and growth. This has been exacerbated by the rapid growth in size of emerging market funds which are less and less interested in fiddly, small positions.

Unfortunately, earlier enthusiasm has generated a lingering reluctance by real estate companies to sell to competitors, holding up a much-needed consolidation process in a fragmented industry. Thats because smaller players continue to believe last years IPO boom correctly valued their potential and are reluctant to sell at new, much lower valuations.

For investors who have bet on smaller firms, the results have been truly horrible. Over the last 12 months to July 25, InPar is down close to 74%, Abyara Planejamento Imobiliario down over 48%, Helbor, which only listed last October, was down from R$11 to just under R$7. Harsh competition is being compounded as firms struggle to raise fresh finance to put them on a footing to compete with bigger rivals. In June, InPar was forced to cancel plans to sell as much as R$460 million of local bonds. Although it gave no reason, bankers say the firm was deterred by lack of interest.

All companies face a number of challenges. Expenses have been shooting through the roof thanks to the new injection of capital and competition. Land prices have been driven higher by competition, workers from managers, to stone-masons and decorators and every step in between have become far more expensive. Last year, 45,000 positions were created in the industry and salaries were up an average of 33%.

Recruitment has been feverish with firms launching generous stock option plans to keep their senior staff walking to the nearest neighbour and that has allowed successful firms to leverage their good performance. Good management is particularly thin on the ground thanks to the small size of the formal real estate industry before its current boom.

The similarity of business models between companies has exacerbated costs rises. Most firms have focused on well-established markets: high-end new residences in upper middle class suburbs of Brazils largest cities. São Paulo, the acme, is seeing launches of 60 buildings per day, according to local magazine Veja.

But it is not all carnage. One of the most notable features of share price performance has been a widening gap between different groups. That means leading, large companies, particularly the two largest firms in the sector, Gafisa and Cyrela, have performed better than their peers. Gafisa shed 10% in the year to July 23rd while Cyrela is up 6.7%.

When you look at todays multiples compared to last year, theres already a lot of differentiation between Brazilian real estate companies, notes São Paulo-based Wilson Amaral, CEO at Gafisa. That mirrors firms on the New York Stock Exchange, he notes, where large companies dominate and there is a large spread of P/Es between large and small companies and across different strategies.

The strongest firms are now emphasising diversification and are able to do so thanks to deeper pockets. Its important to avoid duplication. Gafisa is very diversified and we dont focus on specific neighbourhoods. The biggest danger lies in concentrating risk, says Amaral. The firm is a national player and expanding rapidly over Brazil, he says. It is present in 46 regions and 231 cities in developing housing and 42% of the consolidated land bank is now outside the states of Rio de Janeiro and Sao Paulo.

Cyrela, which has 46 years of experience in domestic homebuilding, and has a leading position and a giant land bank in São Paulo and Rio, is diversifying too. That means it does not have to join in the mad scramble for new land. The firm is well managed and, like Gafisa, has been rapidly branching out into new regions with about 40% of its landbank located outside the key two markets.

Furthermore, Cyrelas size and the dire state of the real estate market means it is starting to acquire rivals, most recently Agra. The deal will immediately give Cyrela a footprint in Brazils northeast, an area that is fast-growing albeit from a low base. Cyrela has also kept a control on costs and its large land bank gives it a cushion of comfort.

Its not just diversification by region but by customer income. Gafisa, for one, is boldly going where few Brazilian real estate companies have dared to go, by entering the vastly under-served market of lower-income Brazilians. The realization that competitors are fighting for a tiny slice of the Brazilian population, coupled with changing economic circumstances that are finally enabling lower middle class families to finance purchases, is rapidly changing the real estate game.

Our product mix will be different this year as its the first time where we are actively targeting low income families, says Amaral. Gafisa launched the brand Fit Residencial and started developments last year to target this segment with homes that cost between R$80,000-200,000 ($51,000-127,000).

The total project launches for Gafisa in 2007 totalled R$2.2 billion, 122% up over 2006. Fit Residencial and Bairro Novo, which launched their first developments during 2007, accounted for 13% of the total launches. This year, the figures will be higher.

Gafisa has also been working to re-balance its debt-equity ratios. Recently, the firm has been increasing debt, says Amaral. Net debt-equity has been 20/80 and debt is now in the mid-20s. It could go up to 60/40, he says. But with debt offerings typically denominated in dollars, debt exposure needs to be hedged, he notes.

The exception among the larger companies has been Rossi Residencial which has lost over 50% of its value over the last 12 months. That is mostly down to earnings prospects which are seen not to be as favourable as rivals. The firm also provided ambitious earnings targets which it is failing to meet. It is significantly lagging peers in achieving fiscal year 2008 estimates and guidance, according to a Deutsche Bank report.

The short-term future for Brazils housing sector certainly looks difficult. But that should give the larger and well-managed companies to start the process of consolidation, develop their land banks and cool the red-hot market for talent, materials and land bank. The future looks bright for those companies that can diversify into new areas and they will emerge stronger from the current wobbly market. With Brazils GDP continuing to hold up relatively well, it can only be a question of time before investors are prepared to put money back into the sector.